Your Taxes; Shelters Can Turn Perilous

By CHARLES DELAFUENTE

Published: February 16, 2003

WHEN William T. Esrey, the departing chief executive of Sprint, disclosed this month that he was being audited by the Internal Revenue Service for using a tax shelter created by the accounting firm Ernst & Young -- and said he could be ruined financially if the I.R.S. ruled against him -- many other Americans wondered about the tax advice they were getting.

The 1990's boom gave many people big and sometimes unexpected gains, prompting some to seek ways to avoid taxes, and perhaps to consider tax shelters. Following are questions and answers about some of the basic issues.

Q. Are tax shelters illegal?

A. Not per se. But different people use the term to mean different things. Broadly speaking, a shelter is anything that lets a taxpayer defer or avoid tax on some amount of current income. Anyone of even modest means can have what might be considered a benign shelter, like a mortgaged house or municipal bonds. The law specifically allows a shelter, in the form of tax credits, for restoring historic structures and investing in low-income housing.

But ''tax shelter'' has commonly come to mean an arrangement or procedure that lets very wealthy people avoid tax on all or most of their income. The Internal Revenue Service calls many of the strategies used, especially by the wealthy, ''abusive tax shelters.''

Q. In what sense is the I.R.S. using the word ''abusive''?

A. The I.R.S. says on www.irs.gov, its Web site: ''Abusive tax shelters exist solely to reduce taxes unrealistically. Abusive tax shelters are often marketed by promising a larger write-off than the amount invested. These schemes involve transactions with little or no economic foundation.'' However, it acknowledges, ''There is no hard and fast definition of abusive tax shelter arrangements.''

Q. How do the arrangements work?

A. Many tax shelters involve an investment that creates deductions or involves transactions intended to shield income from taxation. The seller of an investment or the architect of the plan to move assets around is considered the promoter and usually earns a hefty fee.

Q. What did Ernst & Young promote?

A. One of the strategies involved taking millions of dollars in profits from stock options and delaying taxes for 30 years by passing money to family members.

Q. How could I figure out whether a shelter is abusive?

A. Remember the old adage that if something seems too good to be true, it probably is. A more precise way would be to ask an accountant or a lawyer who specializes in tax issues for an opinion. But no one can offer an ironclad guarantee. And if a promoter insists that the details of the shelter not be shared with advisers, that might well be a red flag.

Q. How would the I.R.S. know if I had a shelter?

A. It might find out in one of several ways. If the shelter created deductions disproportionate to your income, that imbalance might lead to an audit. Very wealthy taxpayers' returns might be scrutinized every year. And because many shelters involve partnerships or other joint enterprises, if one participant is spotted, the I.R.S. might look at anyone else involved.

Q. What happens if someone has followed a promoter's advice and the I.R.S. says the shelter is abusive?

A. If the I.R.S. can prevail, then, in its words, ''investors in abusive tax shelters whose returns are examined may be required to pay more tax, plus penalties and interest.''

Q. Should I go ahead if I like the idea?

A. The answer depends in part on risk tolerance. Some people like living on the edge. But for someone who is going to lose sleep every night over a questionable shelter, the emotional price is probably too high. A potential investor could seek a ruling in advance from the I.R.S., but many shelter investors fear the answer, and are in part playing the odds that their shelter will escape notice.

For a middle-income taxpayer, the savings might not justify the fees involved in buying a shelter, and sophisticated shelters may require the investment of a significant amount of cash to create the promised deductions.

Q. Will the I.R.S. always prevail?

A. If a taxpayer who is challenged does not agree to pay, and there is enough money at stake, the case could well wind up in court. Many shelters exist on a frontier where three parties -- Congress, which writes the tax laws; the I.R.S.; and some accountants and lawyers, who look for loopholes -- are engaged in a constant border war.